Heartland Small Cap Value Strategy 3Q18 Portfolio Manager Commentary

Executive Summary

Rising rates and political uncertainty are raising investor concerns about the future economic growth.

The current excess in valuations for growth and momentum reflects a misguided response to a rational concern.

“Excesses are never permanent.”

—Bob Farrell

Wall Street Veteran and Legendary Investor

Third Quarter Market Discussion

With the eighth Fed Funds rate hike now in the books, and political uncertainty from the upcoming November elections on the horizon, investors are asking “Without a Fed punch bowl, will the economic party come to an end?” After more than nine years of expansion, it’s a fair question. Unfortunately, some of the responses we’re seeing to the uncertainty could lead to disaster.

Instead of focusing on time-tested investment principles like valuations and balance sheet strength, many are ignoring prices and are paying top dollar for growth and momentum. Why? Because they hope that yesterday’s winners will carry the day if economic growth stumbles.

Reefer Madness

Tilray, Inc. (TLRY) is one of the more vivid examples to surface. In less than a quarter, shares for this budding marijuana grower have shot up 13-FOLD giving it a market cap of more than $20 billion at its peak. With the stock registering a nearly 40% gain on a single day last month, we can’t help but wonder if investors have noticed they are paying 500x sales of just $40 million.

Of course no discussion of cannabis and risky investments would be complete these days if it didn’t include Tesla Inc. (TSLA) and Elon Musk. The soap opera of Musk’s behavior and the company’s crushing debt load rolls on. Shares pulled back some during the quarter but still trade at over 100x next year’s estimated earnings and 13x book value. Those valuations strike us as hard to defend on their own—but add in the company’s need to refinance nearly $2 billion in debt in 2019, and they have the makings of a potential disaster for investors.

The above examples may seem like anomalies with little risk to rational investors; however, we’d argue they represent an approach that has been choking off interest in many small, attractively valued companies.

Pent-up Energy

Energy is a prime example of an area unloved and overlooked but filled with what we believe are compelling values. As you can see in the chart below, oil prices are well off their lows of 2015, yet small energy stocks have hardly budged. While the disconnect hurt performance for your portfolio’s holdings in the space this period, it also created an opportunity to pick up a cash-rich, low-cost energy producer, Berry Petroleum Corporation (BRY).

Untapped Value?

Source: FactSet Research Systems Inc. and Russell®, 9/28/2015 to 9/28/2018
All indices are unmanaged. It is not possible to invest direction in an index.Past performance does not guarantee future results.

The independent exploration and production company focuses on conventional oil reserves in the Western United States, primarily in California. Berry possesses a long-lived, high-margin asset base and should be uniquely positioned to generate top-tier returns and positive free cash flow in a broad range of energy prices. This operating model offers great visibility regarding production (the company expects 15% average compounded annual growth rate from 2018-2021) and low leverage—1.2X net debt/2018 estimated earnings before interest, taxes, depreciation and amortization (EBITDA).

With shares trading at just 4.5x estimated 2019 EBITDA, we see Berry as an opportunity to tap into an improving oil market with a business that offers a significant dividend yield and strong free cash flow generation trading at a material discount to net asset value.

Our other two exploration and production holdings in the space are SRC Energy Inc., (SRCI) and Abraxas Petroleum Corporation (AXAS). Both companies had strong performance during the first half of the year, but each were under pressure during the most recent quarter.

However, SRCI has been hampered by a bottleneck in pipeline capacity to transport natural gas out of the Basin where it operates. Additionally, a ballot initiative that could lead to drilling restrictions in Colorado has weighed on shares. We believe the transport capacity issue has begun to ease and we see little chance of the ballot initiative being passed into law.

AXAS has sold off because of similar bottlenecks in takeaway capacity in the Permian Basin, which accounts for about 50% of production. However, we expect output to rebound for the remainder of the year.

SRCI trades at just 6.3x 2019 earnings, while AXAS is similarly discounted at 7.3x. We believe both businesses should enjoy strong 2019 growth production.

Home is Where the Value is

Concerns about the impact of higher interest rates has taken a toll on housing stocks this year including portfolio holdings such as Century Communities, Inc. (CCS).

CCS was founded in 2000 by brothers Dale and Robert Francescon. The two have a successful track record in launching new homebuilding companies and reaping value from them. For example, in 1993 the pair owned and operated the largest builder in Colorado which they sold to D.R. Horton Inc. (DHI) in 1996 at a hefty premium.

CCS is now the 10th largest public builder and, as of 2017, the fastest growing. The company has 5-year compounding revenue growth of over 70%, and its EBITDA has grown at a 61% compounding annual rate. Their strength in the low-priced home segment targeting first-time buyers, we believe, should position it to sustain the impressive growth.

Despite its dominant position among builders, the company is trading at just 6.4x projected 2019 earnings—a significant discount to peers, and less than half the valuation for the S&P 500.

As long-term investors we believe concerns about interest rates are overdone. With eight rate hikes already in the books and the yield curve continuing to flatten, we believe the Fed’s days of tightening are winding down. At the same time, housing starts are well below previous peaks and long-term average, despite a pending surge in demand as the 90 million-strong millennial cohort continues to move out of their childhood homes.

Dangers of Debt

As bottom-up investors, much of our focus is on understanding a company’s financial strength. A look at your portfolio shows that on average, the businesses you own have considerably less debt than those found in the Russell 2000® Index.

When evaluating investment opportunities, we look at things such as debt/capital and debt/cash flow. Simply put, we seek companies that have manageable debt levels and can withstand bumps in the economic cycle.

Unfortunately, strong balance sheets can sometimes deteriorate quickly due to an ill-advised acquisition or an unexpected loss of a critical customer as was the case for two holdings in your portfolio. These respective events created significant pressure on share prices, and the names accounted for the vast majority of negative performance this quarter.

The drop in both companies serves as a stark reminder of how quickly things can change for leveraged businesses. We were too slow reacting to developments and have heightened our focus on taking decisive action when warranted.

Opportunities vs. Excesses

The current excess in valuations for growth and momentum reflects, in our view, a misguided response to a rational concern. Investors are understandably cautious about the ability of companies to grow in the face of rising rates and political uncertainty. By chasing yesterday’s winners, however, investors have created excesses in valuations and as Mr. Farrell rightly noted, excesses are never permanent.

We’ve taken what we believe is a more prudent approach—buy well run companies with strong balance sheets that are trading at discounts on an absolute basis. Our commitment to this time-tested approach is reflected in the valuations below.

Small Cap Value Composite Valuations

Source: Heartland Advisors, Inc., as of 9/30/2018
Price/Earnings and EV/EBITDA are calculated as weighted harmonic average and Total Debt/Capital as weighted average.
Enterprise Value/Earnings Before Interest, Taxes, Depreciation, and Amortization (EV/EBITDA)
These valuations are based on Heartland Advisors’ calculations. Certain outliers may be excluded. Any forecasts may not prove to be true. Economic predictions are based on estimates and are subject to change.Past performance does not guarantee future returns.

The fact that we continue to find exceptional valuations in a nine-year-old bull market is striking and a reminder of the value of a bottom-up approach. We remain unwavering in our focus on finding these compelling opportunities and believe these are the types of companies that will thrive long after today’s market darlings fade from memory.

Thank you for your continued confidence.

Please wait while we gather your results.

Portfolio Management Team

Nasgovitz is Chairman and Portfolio Manager of the Value Fund and its corresponding separately managed account strategy. He also is President and Director of Heartland Funds. He has 50 years of industry experience, 36 at Heartland.

*Performance data is preliminary. Yearly and quarterly returns are not annualized. The Strategy's inception date is 10/1/1988.
**Shown as supplemental information.

The U.S. dollar is the currency used to express performance.

Past performance does not guarantee future results.

The Small Cap Value Strategy invests in small companies selected on a value basis. Such securities generally are more volatile and less liquid than those of larger companies.

Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market.

Heartland Advisors, Inc. (the "Firm") claims compliance with the Global Investment Performance Standards (GIPS®). The Firm is a wholly owned subsidiary of Heartland Holdings, Inc., and is registered with the Securities and Exchange Commission. For a complete list and description of Heartland Advisors composites and/or a presentation that adheres to the GIPS® standards, contact the Institutional Sales Team at Heartland Advisors.

Statements regarding securities are not recommendations to buy or sell.

Portfolio holdings are subject to change without notice. Current and future portfolio holdings are subject to risk.

The statements and opinions expressed in the articles or appearances are those of the presenter. Any discussion of investments and investment strategies represents the presenters' views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. The specific securities discussed, which are intended to illustrate the advisor’s investment style, do not represent all of the securities purchased, sold, or recommended by the advisor for client accounts, and the reader should not assume that an investment in these securities was or would be profitable in the future. Certain security valuations and forward estimates are based on Heartland Advisors’ calculations. Any forecasts may not prove to be true.

Economic predictions are based on estimates and are subject to change.

There is no guarantee that a particular investment strategy will be successful.

Sector and Industry classifications are sourced from GICS®.The Global Industry Classification Standard (GICS®) is the exclusive intellectual property of MSCI Inc. (MSCI) and S&P Global Market Intelligence (“S&P”). Neither MSCI, S&P, their affiliates, nor any of their third party providers (“GICS Parties”) makes any representations or warranties, express or implied, with respect to GICS or the results to be obtained by the use thereof, and expressly disclaim all warranties, including warranties of accuracy, completeness, merchantability and fitness for a particular purpose. The GICS Parties shall not have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of such damages.

Heartland Advisors defines market cap ranges by the following indices: micro-cap by the Russell Microcap®, small-cap by the Russell 2000®, mid-cap by the Russell Midcap®, large-cap by the Russell Top 200®.

Small-cap and large-cap investment strategies each have their own unique risks and potential for rewards and may not be suitable for all investors. Small-cap investment strategies emphasize the significant growth potential of small companies, however, small-cap securities, are generally more volatile and less liquid than those of larger companies. Large-cap investment strategies emphasize the stability of large companies, however, large-cap securities are more susceptible to momentum investments and may quickly become overpriced or suffer losses.

Because of ongoing market volatility, performance may be subject to substantial short-term changes.